Corporate Venture Capital and the Pharmaceutical Industry
Introduction
In light of increasingly strained healthcare budgets, patent expiration, impact of generics, and increased regulatory scrutiny, pharmaceutical firms are under increasing pressure to improve R&D productivity. But instead, productivity levels have tumbled in recent years. In that light, it is important to note that traditional pharmaceutical firms are still generally involved in all three phases of the pharmaceutical value creation process: from breakthrough science, through processing, to commercialization of medicine. However, it can be questioned whether this integrated model still makes sense. As will be addressed in the paragraphs below, front-end innovation requires very distinct capabilities from back-end development programs.
Now, the aim here is not to conclusively argue whether breaking up the pharmaceutical R&D chain makes sense. Instead, I attempt to describe how and why, to combat a decrease in R&D productivity, Big Pharma has increasingly started to consider sourcing innovation externally, specifically by way of corporate venture arms that invest in biopharmaceutical firms as a mode for external growth. I will do so by taking on a real options theory perspective, which draws the analogy between financial options and a firm’s approach to strategic management broadly as well as its capital investment outlays specifically.
Characterization of the pharmaceutical industry
Pharmaceutical industry dynamics can at least partially be explained by the patent system that underlies undergirds it. Large research-based corporations tend to invest heavily in the identification of new product candidates. Most candidates do not end up on the market, as the drug could prove ineffective during trials, or to have severe side effects, or to be non-compliant with the numerous regulatory stipulations. When a drug does end up on the market, however, the patent system guarantees that the company responsible for its discovery and development retains exclusive rights to commercialization. As soon as the patent expires (typically after 10–12 years), the drug may be replicated by generic pharmaceutical developers.
This has significant implications for the way in which firms are structured and the way in which they operate. More specifically, while it is typically costly, time-consuming, and risky for a research-based firm to bring a drug to market, generic pharmaceutical firms are comparatively cheaper and less risky to operate.
Although generic pharmaceutical firms engage in process-oriented R&D, they do typically incur lower product R&D costs. Producers of generics know more in advance about whether a particular drug has shown to be valuable and commercially successful. Demand is better understood and the product has commonly been well-established in the market when the drug comes off patent, so marketing costs tend to be lower as well. Generic pharmaceutical firms can therefore be seen as being in commodity markets, competing on costs; research-based firms can be seen as being in differentiation markets, competing on quality.
Value creation in the (bio)pharmaceutical industry
More generally, the inherent commercial viability of a firm seems largely dependent on its capacity to capture value effectively. Within the pharmaceutical industry specifically, value is created through a sequence of phases ranging from discovery (including basic and applied research) trough processing (including development, trials, and approval), to commercialization (including manufacturing and marketing). Not every pharmaceutical firm, however, chooses to engage from product conceptualization to product sale.
Instead, three different approaches stand out to me: the producer model, the creator model, and the provider model. I have visualized the three different approaches as follows:
Producer
As depicted, the producer model refers to firms that engage in the process from basic research to the actual marketing of an asset. Value, as such, is added as the product progresses through subsequent links in the chain, from discovery through commercialization. The traditional Big Pharma firm can be thought of as a producer. It follows that the R&D department is expected to deliver adequate product candidates to the development department (i.e. if the product candidate is not in-licensed from a third-party), which in turn performs the clinical tests and related work. Once approved and manufactured, the marketing department typically takes over and ensures alignment between product- and corporate strategy. Importantly, such vertically integrated producers are often organized by therapeutic areas (e.g. for ophthalmology, oncology, or immunology).
Global Blood Therapeutics (GBT) is an example of a pharmaceutical firm that has chosen to adopt a producer approach to value creation. GBT is specifically focused on treatment of sickle cell disease (SCD), with Voxelotor as lead product candidate. It intends to go to market by way of its own commercial infrastructure, as market risk of commercialization is regarded as low:
“Approximately 100,000 Americans have been diagnosed with SCD and 80% of those living with SCD reside in 17 states. Many SCD patients receive care from a hematologist or another sickle cell care provider. Thus, the US commercial market for SCD is highly concentrated both in terms of geography and prescribing audience. We expect to be able to efficiently support the commercial launch of Voxelotor by building our own targeted commercial organization including internal sales personnel, key payer account management, marketing and distribution support. […] We currently do not expect that we will require large pharmaceutical partners for the commercialization of our product candidates, although we may consider partnering in certain territories, New Molecular Entities, or NMEs, or indications for other strategic purposes.”
Creator
The creator model refers to firms that create value through basic research and delivery of a proprietary asset. The resultant product candidate (i.e. a proof of concept) may or may not have been through Phase I and Phase II clinical trials and approved by a regulatory entity such as the Food and Drug Administration in the United States. The creator is not engaged in the actual commercialization itself, but instead typically closes co-commercialization agreements with strategic partners that take on responsibility for manufacturing at scale as well as the marketing process.
Voyager Therapeutic is an example of a pharmaceutical firm that has chosen to adopt a creator model. Voyager Therapeutic is a clinical-stage gene therapy company focused on developing treatments for patients that suffer from severe neurological diseases (e.g. epilepsy or Parkinson’s disease). It intends to develop promising product candidates, for which it will partner with third-parties for commercialization.
To illustrate, Voyager has an option agreement with AbbVie (a major pharmaceutical firm), in which the former is responsible for research, IND-enabling studies, and Phase-I clinical trial activities and costs (AbbVie, 2018). Beyond the completion of Phase-I clinical development, AbbVie has the option to license Voyager’s tau antibody program (intended to address, amongst others, Alzheimer’s disease) and would then lead further clinical development and global commercialization for the product candidates pursuant to the agreement. The deal between AbbVie and Voyager entails a $69 million upfront payment from Abbvie to Voyager and up to $155 million in potential preclinical and Phase-I option payments, as well as up to $895 million in development and regulatory milestone payments and tiered royalties on global commercial net sales of the asset:
Said Steven Paul, M.D., president and CEO of Voyager:
“Combining AbbVie’s leadership and deep expertise in monoclonal antibody discovery, development, and commercialization and our ability to vectorize monoclonal antibodies is a natural fit, and we are very pleased to collaborate with AbbVie to advance this strategy towards the clinic in an effort to bring innovative treatments to patients. This collaboration also represents an important advance in our strategy to leverage our AAV gene therapy platform and programs through partnerships with biopharmaceutical companies that bring complementary expertise and capabilities, in addition to capital.” (AbbVie, 2018).
Provider
The provider model refers to firms that create value solely through the first phases of the R&D chain, before development (i.e. a pure focus on basic- and applied research), and that focus on a particular technology platform that could consist of (i.a.) vast chemical libraries, high throughput screening capabilities, or enormous genetic databases. These firms employ their platforms to industrialize the process of drug discovery and, as such, aim for increases in productivity, efficiency, and quality. Providers typically collaborate with strategic partners for development and commercialization and receive sizable up-front payments as well as research funding in return, with rights to milestone payments and royalties. These partnerships tend to serve as source of income, but also as validation for the technology platform itself.
Sirenas is an example of a firm that chose to adopt a provider model. Sirenas is a drug discovery company that is focused on treatment of cancer. Its proprietary technology platform, dubbed ATLANTIS, uses data mining and machine learning approaches to reveal therapeutic potential of microbiome collections. The firm has signed a collaboration agreement with Bristol-Myers Squibb to deploy the platform against particular (and undisclosed) challenging therapeutic targets to identify product candidates. Under the terms of the agreement, Sirenas receives an upfront payment and success fees from Bristol-Myers Squibb.
Said Sirenas CEO and cofounder Jake Beverage:
“We believe science-focused pharmaceutical companies can benefit from our innovative approaches to access breakthrough chemistry in delivering drug candidates for difficult biological targets. We look forward to a fruitful collaboration with Bristol-Myers Squibb to identify potential new therapies to treat unmet medical needs.”
Finally, I would highlight that it seems not uncommon for firms to evolve from being a pure provider (e.g. as a university spin-off) into a producer (e.g. as a full fledged pharmaceutical corporation). Besides that, firms may choose to go for a portfolio approach to value creation models, in which it acts as a provider when licensing out access to its technology platform, as a creator when licensing out the rights to commercialization of a Phase-II drug that is not core to its strategy, and as a producer in bringing to market those product candidates where it has a competitive advantage — an approach adopted by Argenx, as displayed below:
In sum, when coming to a characterization of the fit between Big Pharma corporate venture arms on one end and biopharmaceutical firms on the other, an understanding of how value is created and captured in the sector is key. However, it is important to not evaluate the potential in a vacuum and to take the market dynamics into account, which are described in the paragraphs below.
Key trends in the pharmaceutical industry
Trend 1: Increased regulatory pressure
Recent innovative technologies and treatment ideas are altering how care is delivered and how pharmaceutical firms engage in the drug discovery and development process. As is often seen where such new practices emerge, new regulatory policies are swift to follow. This adds complexity to the approval and reimbursement process. Indeed, public distrust of the industry and the commonly conservative outlook of regulatory bodies has led to progressively higher hurdles to clear for the efficacy and quality of new pharmaceuticals, leading to multiple submissions for drug approval and elaborate documentation so as to meet clinical trial standards. Simultaneously, however, regulators aim to fast-track innovation and license pharmaceuticals more efficiently that demonstrate positive outcomes. The FDA, for example, has multiple paths towards accelerated approval for drugs that treat serious diseases and are in everyone’s interest (e.g when the drug is first of its kind).
Trend 2: Payer pressure
Approximately half of the managers active in the pharmaceutical industry considers payer pressure as having the most significant impact on commercial operations. Downward cost pressure is projected to intensify as healthcare systems attempt to simultaneously cope with rising demand and flat or declining budgets. The result may be an increased shift away from brand-name drugs to lower-cost generics. Interestingly, some brand-name manufacturers have already responded by offering outcomes-based pricing, where rebate levels are linked with a predetermined outcome in the target population. However, the power of these type of contracts to actually curb spending can be questioned. That is to say, the current feasibility of outcomes-based pricing is limited to a small subset of drugs and metrics available for their evaluation and no evidence has been found as of yet that these contract result in less spending or better quality.
Trend 3: A decrease in R&D productivity: Eroom’s Law
Sustainable growth of the pharmaceutical sector depends on steady R&D productivity, with a positive ROI, that is able to drive future revenues which can be reinvested back into R&D. The legislative and payer trends described above serve to further accentuate the productivity imperative that firms face today. Instead, however, the number of FDA-approved drugs per billion US dollars of R&D spending has halved roughly every 9 years since 1950 (adjusted for inflation). This steady decline in R&D productivity, dubbed Eroom’s Law (note: Moore’s Law, backwards) is particularly remarkable in light of the massive strides that have been made in terms of the scientific understanding of particular diseases and technologies (e.g. combinatorial chemistry, high-throughput compound screening, and three-dimensional protein structure mapping).
Numerous rationalizations have been presented that attempt to explain the decay. It has been suggested that the decline in global R&D productivity may be associated with an increasing concentration of R&D investments in high-risk areas: unmet therapeutic needs that would promise less competition and would therefore be attractive to explore, but entail lower probabilities of success. Others argue that the decrease in R&D productivity is due to rising drug development costs. Total capitalized costs of bringing a drug to market were shown to have increased from the early 1980s at a CAGR of 8.5% above price inflation. Parenthetically, it is important to note that these numbers vary with company size and type of drug product under consideration.
Alternatively, it has been proposed that the decline may be explained, more fundamentally, through a simple law of diminishing returns. That is to say, with every newly approved drug, the back catalogue of pharmaceuticals expands, improving the standard of care. This makes it increasingly costly and difficult to attain incremental improvement. The better the standard of care, the more expensive it becomes to improve further. As a result, pharmaceutical companies spend more in return for diminishing incremental benefits for patients, which would decrease return on investment. In contrast with other industries that also heavily depend on intellectual property (e.g. the music or movie industry), customers in the pharmaceutical industry do not get ‘bored’ with earlier creations (which would have maintained demand for novelty). Said Scannel, Blanckley, Boldon, and Warrington (p. 3, 2012): “Imagine how hard it would be to achieve commercial success with new pop songs if any new song had to be better than the Beatles, if the entire Beatles catalogue was available for free, and if people did not get bored with old Beatles records. Yesterday’s blockbuster is today’s generic”.
Trend 4: A shift in focus from primary care blockbusters to specialty care
The pharmaceutical industry traditionally adhered to a ‘blockbuster’ model, in which a single product was responsible for a significant share of revenue and guided a firm’s strategic direction. While drug discovery and development is expensive, characterized by long development cycles, and rife with risk, the assumption for long was that new blockbuster drugs (described as generating revenue of at least $1 billion) could continue to be invented at regular intervals, the returns of which would fund future R&D efforts as well as offset some of the losses to the sale of generics.
More recently, however, the sustainability of the blockbuster model has been drawn into question. As described, R&D productivity has been on a steady downward trajectory. Now, partially due to this decline, but also because of (i.a.) a better understanding of underlying disease biologies, a more favorable regulatory framework, and shorter development timelines, the industry has shifted attention away from a primary care blockbuster mindset to a focus on specialty medicine, which is generally classified as costlier and more complex.
In sum, the pharmaceutical industry is under pressure from multiple angles. An increase in the quality and efficiency of R&D activity may help to provide relief to at least some of this pressure. It is my aim to describe how Big Pharma has been trying to achieve this by investing in small biopharmaceutical firms and why this collaboration is increasingly given shape by way of a corporate venture investment. First the corporate venture capital environment in the pharmaceutical industry broadly will be described, after which the potential of biopharmaceutical firms is highlighted.
Corporate venture capital in the pharmaceutical industry
Corporate venture capital (CVC) refers to those transactions where an established corporation purchases a minority stake in a start-up firm that is typically not publicly traded. The CVC rationale seems to rest on at least two key premises. First, it is assumed that the knowledge required to spur innovation often lies beyond the boundaries of the incumbent corporation. Second, start-up firms show potential as an important source of such knowledge. Further, two dominant objectives stand out that explain why established firms engage in CVC: some investments are strategic and made with the intention to ultimately increase sales and profits of the firm’s own business, while others are financial in nature and are made purely to generate attractive returns.
The pharmaceutical industry has a strong tradition of CVC activity. The proportion of companies with dedicated CVC arms is approximately 60% (notably, just the technology industry has a higher degree of CVC penetration!). This can partially be explained by the fact that the pharmaceutical industry has simply been active for longer relative to industries that are newer to the CVC field (e.g. transportation, oil, construction).
I study the CVC activity in the pharmaceutical industry here. To do so, I queried Zephyr’s global database of corporate M&A, IPO, PE, and VC deals for transactions that were characterized as (i) financed by corporate venture capital, (ii) in which the acquirer corresponded with the pharmaceutical industry’s NAICS 2017 primary code (i.e. 3254), and (iii) that took place between 2000 and 2018. In total, 420 deals were found to match the listed criteria. Between 2002 and 2017, the number of deals was found to have increased at a CAGR of 9%.
To further characterize the nature of the CVC investments, I distinguished between ‘biopharma’ and ‘other’ investments. To do so, I assessed the target’s primary UK SIC and NACE codes. The primary code refers to the activity that contributes most to the total added value of the targeted firm. The primary code for the biopharma segment as classified by UK-SIC (2007) and NACE are 72110 and 7211 respectively and were described as “Research and experimental development on biotechnology”. The number of biopharma deals was found to have increased at a CAGR of 17% (versus a CAGR of 9% for the total number of CVC investments), to the extent that biopharma accounted for over 60% of the total number of deals in the pharmaceutical industry in 2017 (up from approximately 30% during the beginning of the years under study) (Fig. 3). Over the past 15 years, both in terms of the absolute amount of total deals as well as in terms of the absolute amount of biopharma deals, Celgene emerges as the most active pharmaceutical firm (as measured by the total number of deals completed) (Table 1). This may be explained by an attempt to move away from the blockbuster model that Celgene seemed to rely on previously, in which it depends for over 63% of overall revenue on Revlimid (i.e. a cancer medicine that generated $8.2 billion in sales last year). In other words, 63% of revenue could face fierce competition as the drug comes off patent in 2020, which would shed light on why Celgene has been actively looking to diversify its pipeline.
In terms of market capitalization, Celgene is among the three biggest biopharmaceutical firms in the industry, which may explain the prominence of biopharma deals in its portfolio. Still, the increased importance of the biopharmaceutical CVC for the industry in general is significant. Several explanations could be offered. Below, I highlight three reasons why Big Pharma may be increasingly interested in smaller biopharmaceutical firms: (i) the ability of biologics to target molecular processes that a typical small-compound drug cannot, (ii) the higher probabilities of progressing through the various phases of trials through approval, and (iii) the prospect of greater returns.
Biologics’ potential
1. Wider product scope
First, biopharmaceuticals have the potential to address previously untreatable diseases. The science behind biologics has had a real impact on an increasing number of disease categories, some of which were deemed as untreatable by way of small-molecule drugs — for rheumatoid arthritis or for certain autoimmune diseases for example. Innovation around immunotherapies, antibody drug conjugates, and various gene and cell therapies are all making progress towards commercialization over the coming years. As such, research around biopharmaceuticals stands to increase our understanding of the interaction between drug and patient, which makes for improved targeting capabilities, higher efficacy, and fewer side effects. I found the superior ability to treat previously untreatable conditions to be reflected in the number of new entities that are designated as first-in-class (as a percentage of the total number of new compounds approved), which over the past 8 years has generally been in favor of biologics, visualized below (Fig. 4):
If the decline in R&D productivity is indeed, as described, due to a law of diminishing returns in treatment areas where small-molecule drugs are dominant, then the capacity of biologics to address disease categories that their small-molecule counterparts have not been able to tackle may serve to mitigate some of the decay.
2. Lower levels of attrition
Second, biopharmaceuticals offer higher phase-transition probabilities and an increased likelihood of final approval. As described earlier, biologics are more complex but also more precise than their small-molecule counterparts. It may be precisely this higher degree of target specificity that explains why biologics typically enjoy a higher likelihood of approval (LOA) (Fig. 5). The LOA was shown to be 11.5% during Phase I, 17% from Phase II, 50% from Phase III, and 88% from new drug application (NDA). For small molecule NMEs, LOA was calculated to be just 6% for Phase I, and 10%, 38%, and 78% for the subsequent phases. Note that biologics have almost double the LOA from Phase I.
3. Higher projected returns
Third, the average biologic is estimated to provide greater returns than a typical small-molecule compound would (i.e. an NPV of $1.26 billion and an IRR of 13% vs. an NPV of 65 million and an IRR of 7.5%). This can be explained by biologics’ higher average peak sales and a slower decay in sales beyond patent expiration. The differential in peak sales should be considered in light of biologics’ significantly higher price point. To illustrate: Brineura, which is a biweekly enzyme replacement therapy that delays loss of walking ability, costs $27.000 per injection (or over $700.000 for a full year’s treatment). The slower decay in sales is at least partially due to biologics being more difficult to replicate because of their greater complexity, which results in biosimilars taking longer to get to market than a generic would after the expiration of a small-molecule patent.
The biopharma firm as vehicle for exploration
As outlined before, many large pharmaceutical firms still seem to adhere to a producer model of value creation and engage in the full process from identifying promising new molecules, through development and clinical trials, to promotion by way of an elaborate marketing and sales presence. Their emphasis on both discovery and commercialization is indicated by heavy investments in both R&D and sales & marketing. However, the extent to which this level of integration still makes sense is questionable, especially so in light of the increased pressure from regulators and payers, shifts in demand, and the decline in R&D productivity described above. It has been argued that front-end innovation activities from molecule discovery to clinical proof of concept differ significantly from the distinct capabilities required for the successful planning and execution of bringing a drug to market.
Now, to instead switch to a creator or a provider model of value creation does not seem like a feasible solution for the fully integrated Big Pharma corporation. Their core strength seems to lie in the ability to commercialize a product effectively and to deal with the many complexities that the pharmaceutical industry offers (e.g. in terms of legislation and characteristics of demand). Still it may be precisely this primarily market-driven inclination that is directly at odds with the science-driven perspective needed for successful drug discovery and development.
Conversely, small biopharma firms frequently emerge around the fruits of basic research conducted by scientists, where technological expertise is a core competence. These small firms are less risk-averse, seek out unproven opportunities, are less constrained by big firm bureaucracy, are typically lean, and can move cheaply and quickly during the discovery and initial development phases. This may explain why, as in previous years, 76% of new molecular entities approved in 2017 originated from smaller or mid-sized firms (i.e. that are not part of the 30 biggest pharmaceutical firms) and why just 6 new drugs approved in 2017 were discovered by organizations that are part of the top 10. Still, these small firms often lack the organizational and operational knowledge required to bring a drug to market
For a big pharma corporation to foster an environment that is hospitable to effective new drug development in an integrated producer model, the firm would need to address the obstacles that are common in large organizations attempting to establish innovation in general, ranging from internal politics to cultural issues, budgetary concerns, tight timelines, and strategic misalignment. More specifically, it is important to highlight that all innovation project portfolios are subject to some degree of attrition, which may be due to technical, clinical, strategic, or financial reasons. Technical or clinical attrition refers to when a compound is unable to exhibit efficacy or safety and as such is not approved. Strategic or financial attrition follows when the commercial outlook has changed (e.g. due to R&D strategies that are shorter lived than the R&D projects themselves). Now, strategic attrition is, first, estimated to account for over half of all pharmaceutical project terminations and, second, thought to be much more prevalent among integrated firms. Notably, if that finding holds true, it would imply that R&D output would double if the non-strategic projects were provided a chance to succeed in different environments, such as those found in provider or creator contexts.
As described, the highest degree of attrition occurs in the early phases of development. Once a compound passes on beyond phase II, it has a reasonable likelihood of being brought to market. To restate, the overall likelihood of approval from Phase I onwards is 11.5% for biologics and approximately 6% for small molecule compounds. Stated otherwise, there is a 90% probability that projects in Phase I will never contribute a dollar in sales. From Phase III onwards, we saw the likelihood of approval jump to 51% for biologics and 30.8% for small molecule compounds. As such, Big Pharma corporations could significantly improve their risk profile and overall R&D productivity by getting out of the initial phases of development and instead shift focus on the development of assets obtained from Creators or Providers that have already cleared those stages. This would then suggest a fourth approach, which I have visualized in orange below, as the ‘Adopter’ model.
In sum, the paragraphs above have described how the Big Pharma firms that choose to follow the producer model are particularly strong in terms of exploitation, where smaller biopharma firms’ core competency tends to lie in exploration. The question may therefore be posed why the former does not choose to source their entire pipeline externally, to be able to focus on managing development at scale, navigating regulatory complexity, monitoring trends in demands, and adjusting their marketing approach accordingly. Now, my aim here is not to argue definitively that Big Pharma should drop discovery activity altogether, although I do attempt to describe why Big Pharma corporations increasingly consider biopharmaceutical firms as a means to mitigate the decline in R&D productivity: precisely because of the (i) wider product scope, (ii) lower levels of attrition, and (iii) greater projected returns addressed earlier. The small biopharmaceutical firm, in turn, stands to benefit from Big Pharma’s financial resources as well as the developmental and regulatory expertise needed to bring a drug to market. As such, the former would act as a science-driven research unit; the latter as a market-driven development unit. Now that I have established why I believe there is a fit between the two, the paragraphs below will elaborate on why Big Pharma may increasingly choose corporate venture capital to execute a collaboration. I will do so through a real options theory lens.
A ‘real options’ perspective on corporate venture capital
A financial option refers to a derivative instrument whose value is derived from the worth and characteristics of the underlying financial securities. Financial options grant the right to buy or sell an underlying financial asset against a specified price (the strike price) within a fixed period of time. Traders purchase financial options primarily to speculate, to hedge current holdings, or to generate income through writing an option.
The theory of real options originated in the idea that a corporation’s investment opportunities could be seen as a financial option on real assets (e.g. a put or call option) and emerged in part out of a dissatisfaction with traditional financial techniques such as the net present value approach. These techniques were said to be unable to capture management’s flexibility to adapt and revise decisions in response to potentially unexpected developments in the market.
That is to say, traditional DCF approaches would make implicit assumptions with regards to an expected scenario of cash flows and, as such, assume a passive commitment to a static operating strategy. In actuality, however, the market is rife with change, uncertainty, and competitive interactions. Therefore, the realization of cash flows is likely to differ from management’s expectations. As uncertainty about market conditions resolves, management may be in a position to adjust its operating strategy so as to capitalize on favorable opportunities or to mitigate losses, hence the similarity to financial options. Many of these so called real options to (i.a.) defer, switch, or abandon occur naturally, but others can be planned and built in from the outset, at some extra cost. This phased approach of capital investment, where the required investment is not incurred as a lump sum up front, provides valuable opportunities to default at any given stage. Each phase can as such be viewed as an option on the value of subsequent phases by incurring the cost outlay that is necessary to proceed to the next stage. These options seem particularly valuable in R&D heavy industries, especially where markets are uncertain and development cycles are long; three criteria that the pharmaceutical sector fulfills.
In the figure below, I have illustrated a simplified example of real options that can provide managers in the pharmaceutical industry with valuable operating flexibility and adaptability to a dynamic strategic environment when collaborating with small biopharma firms in a CVC model. Suppose that the CVC department of a Big Pharmaceutical firm comes across an interesting new biologics proposition. If both sides of the table see value in collaborating, then initiating further development of the product candidate may entail exploration costs (e.g. for labor or machinery and other equipment). This is visualized as up-front costs below (I1). This will be followed by additional capital outlays for taking the drug through subsequent phases of the development process (I2, I3). However, as described previously, the likelihood of failure in the initial stages is significant. During drug development, if market conditions deteriorate or if the product candidate proves technically unfeasible, management may also choose to either reduce the scale of operations by a certain percentage (Is) of the last outlay (explicitly specified prior to the collaboration) or could decide to forgo further investment altogether if a project does not meet the predetermined milestones, in which case the option would be “out of the money” and whereby the firm would want to prevent subsequent commitments (I2,I3). Finally, if market conditions turn out more favorable than anticipated, management could choose to expand their commitment (IE) through cash flow rights in the form of convertible securities, again set prior to the collaboration.
It could be argued that the logic of real options can be applied beyond a CVC model as well, particularly in regard to internal R&D investment within a pharmaceutical firm. However, as outlined in the paragraphs above, Big Pharma corporations that have chosen a producer approach commonly find that their internal R&D efforts are subject to decreasing returns. Hence, it makes sense for Big Pharma to look outward. In that light, CVC is often compared with an acquisition as an alternative mode for external growth. From a real options perspective, however, acquisitions prove limiting. That is to say, acquisitions present heavy commitment instead of flexibility, they are typically one-time transactions with little possibility for subsequent investments, and it is much more challenging to divest an acquisition than it is to liquidate a minority equity stake in a CVC investment. Additionally, the internal and external uncertainty for the pharmaceutical industry broadly, and the biologics segment specifically, enhances the value of maintaining flexibility to adjust investment decisions and, as such, significantly increases the value of the real options found in CVC. By deferring all-out commitment, the large pharma corporation limits its exposure to market uncertainty. The limited downside combined with significant potential upside is indeed reminiscent of the asymmetry found in financial markets.
In sum, I have attempted to show until here why large pharmaceutical corporations increasingly consider small biopharmaceutical firms as a source for external corporate growth and why CVC would be preferable as a mode of investment, at least from a real options perspective. Finally, in the paragraphs below, I hope to provide more color around the nature of these type of investments by going over three specific examples.
Examples of CVC investments in small biopharma firms
1. Aviir Inc and Merck’s Global Innovation Fund
In leveraging Merck’s own vast R&D based global network, the Global Health Innovation Fund focuses on investing in firms with proven technologies or business models where Merck’s expertise can bring value. Typical investments are small (on average between $5–7 million) and the fund has over $500 million under management. Aviir Inc. is a biopharma firm that is focused on preventing cardiovascular diseases. Its flagship technology is a test for assessing risk of future cardiac events. In 2011, Aviir announced the completion of the final tranche of financing, which amounted to $10 million, bringing the round to a total of $30 million. The investment was said to be used to build out a commercial infrastructure and to speed up launch. Merck led the round, but was the only pharmaceutical firm that participated. Aviir filed for bankruptcy in 2015.
2. Merus B.V. and the Novartis Option Fund
The Novartis Option Fund, based in Basel, is part of the Novartis Venture Funds, which collectively have over $850 million in capital under management and invest globally in various pharmaceutical firms across therapy areas. Merus B.V. is a small, Dutch biopharmaceutical firm that is focused on building a portfolio of various innovative antibodies for cancer therapy. In early 2013, the firm presented research findings and preclinical data of a product candidate that could be used to treat acute leukemia and that emerged from Merus’ proprietary technology platform; in late 2013, they announced a $42 million extension to a Series B financing round that brought the total round to a sum of $65 million. Besides the Novartis Option Fund, other notable corporate investors that participated in the round include Johnson & Johnson and Pfizer. Merus indicated to be using the funds to broaden its portfolio of pre-clinical programs as well as to bring lead programs into phase I clinical testing and Novartis’ participation in the Series B round was contingent on milestones that were set back in 2010, when both entered into an option agreement for an exclusive license to one of Merus product candidates. This deal entails an exclusive license for commercialization, in return for which Merus is entitled to milestone and license payments that exceed $200 million as well as royalties.
3. Intellia Therapeutics and the Novartis Venture Fund
Intellia Therapeutics is a leading genome editing firm focused on the creation of proprietary CRISP/Cas9 technology therapeutics. Interestingly, Novartis was a founding investor in the platform. This may be explained by their direct interest in how this kind of gene editing technology develops and could potentially be tied into Novartis wider cancer treatments; indeed, Novartis itself is heavily active in genome editing and Crispr technology. Pursuant to the original agreement between the two, Novartis holds exclusive rights to develop any and all programs that revolve around an undisclosed type of technology. Besides a $10 million up front investment and prospects for various milestone payments, Intellia will also receive access to Novartis’ proprietary nanoparticle technology, which is used in genome editing applications. No other corporate investors participated in the round.
Notably, while the exact structure of CVC deals often remains rather opaque, it seems like the nature of the deal differs depending on the model that the target firm has chosen to adopt. Aviir Inc., as a producer, has chosen to build out a proprietary commercial infrastructure. Merck’s investment therefore seems to revolve more around providing financial resources than it does around a technological exchange. Merus B.V. seems most closely aligned with the creator model, in which it focuses on getting product candidates to a proof of concept stage, but it does not have a proprietary sales and marketing infrastructure in place. As such, Novartis’ investment is mostly focused on potentially benefitting from exclusive commercialization rights to interesting compounds and programs under development. Intellia Therapeutics, in turn, can be seen as a provider in the sense that it purely focuses on a particular type of technology. This CVC investment seems the least capital intensive, but the most intellectually intensive, being engaged from the very beginning of the company onwards.
Conclusion
I have attempted to describe why it is that Big Pharma corporations tend to increasingly consider small biopharma firms to combat a decline in R&D productivity and why it is that a CVC model is seen as the appropriate structure to do so. I have proposed that biopharmaceuticals (relative to a conventional focus on small-molecule drugs) provide greater returns, offer wider product scope, and show higher likelihoods of approval. The large pharmaceutical firm’s expertise in exploitation was contrasted with the small biopharmaceutical firm’s proficiency in exploration. If the former would source from the latter, both stand to benefit. Going forward, however, there are multiple challenges to be taken into account. Three are highlighted below.
First, it remains to be seen if the contribution of the biopharmaceutical segment of the industry is actually able to revitalize the market as a whole. Perhaps it does mitigate some of the decline in R&D productivity, but if other core causes for deterioration are not addressed, the linear downward trend may well continue. Some industry analysts have deemed the sector as a whole to be on the brink of a ‘terminal decline’, with returns on investment in pharmaceutical R&D already being below the cost of capital, with projections to hit zero within a few years time — despite the industry’s efforts to reverse the trend.
Second, in light of downward cost pressure, payers may find it increasingly tough to justify annual treatment costs for biopharmaceuticals, which have been shown to run into the $100,000s. Governments in developed as well as emerging markets understand the crucial role that biopharmaceuticals play in improving healthcare outcomes and, as such, are heavily supporting other ways to address the demand for treatment. The result of these pressures, paired with expiration of patent protection on lucrative biopharmaceuticals, is likely to spur the rise of biosimilars.
Third, I have described how (i) the traditional pharmaceutical firm is still largely grounded in development of small-molecule drugs and (ii) how the development of biopharmaceuticals tends to be exponentially more complicated. Given these two propositions, it seems fair to question whether Big Pharma is able to seamlessly integrate the complexity of biopharmaceutical operations into existing supply chains. It is only through a blend of strong science and deep operational expertise that the potential to transform the lives of millions of patients around the globe will be fulfilled. The potential of biologics is clear, but that potential is worth nothing if it cannot be realized in the first place.
